Feb 07 2013
Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition
Related Unit: IB Economics Unit 4.7 – Balance of Payments (Unit 3.3 in the new IB Economics syllabus)
Topic: The Marshall Lerner Condition and the J-Curve
- For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
- For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
- For students to evaluate the argument that a country will always benefit from a weaker currency.
Test of prior knowledge:
- Define ‘price elasticity of demand’ and explain how it is measured.
- With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
- Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
- How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?
Each student should research the forex market for his or her home country in the United States. If you are American, research the forex market for the dollar in Europe.
Complete three pre-readings:
- Using Yahoo Finance, research exchange rate data from the two countries two years ago up to today.
- Use Yahoo’s software to create two a line graph plotting the value of your currency in terms of dollars. For your initial graph, show the exchange rates over a two year period. For example:
The exchange rate of Japanese Yen in the United States over the last two years:
Take a snapshot of your two-year exchange rate diagram in OneNote, then copy and paste the questions below into the page.
Questions to answer in OneNote:
- Write a brief description of the changes in your country’s exchange rate over the last two years. (2 marks)
- Focus on two specific time periods from during the last two years: One in which your currency appreciated noticeably and one in which it depreciated noticeably. These could be periods of just a couple of days or longer periods of weeks or more. Highlight these in two different covers in your graph.
- Describe what is happening to your currency during the two time periods you highlighted in your chart. (2 marks)
- Explain TWO factors that may have caused the currency to change in value. (2 marks)
- Given the changes to the exchange rate you identified above, what would you predict would happen to your country’s current account balance over the two periods identified? Explain. Following appreciation – in the short-run and in the long-run. Following depreciation – in the short-run and in the long-run. (4 marks)
- Why does the price elasticity of demand for imports and exports increase over time following a change in a country’s exchange rate? (2 marks)
- Draw a J-Curve showing the likely change in your nation’s current account balance following the period of depreciation of its currency shown in your chart above and explain its shape, referring to your country’s currency. (2 marks)
- For both the period of appreciation and the period of depreciation you identified above, explain the impact of the change in exchange rates on the following (4 marks)
- a firm that imports its raw materials from the other country
- a firm that exports its finished products to the other country
- consumers who buy imports from the other country
- a firm that produces good for the domestic market and competes with firms from the other country
Read the following article: ‘How Far Will the Dollar Fall?’ by Richard W. Rahn. Based on the extracts below, answer the questions that follow.
Some applaud the dollar’s fall because they believe it makes U.S. exports less expensive and that higher demand will cut the trade deficit. The downside of a low-value dollar is that it makes all the imports we consume more expensive, including raw material and parts used by U.S. businesses, and makes it costlier for U.S. dollar holders to travel or invest outside the U.S. A continued drop in the dollar’s value could destabilize the international economy, leading to a worldwide recession.
- Why might the weaker dollar worsen the US trade deficit? Under what conditions would the weaker dollar improve America’s trade deficit? (2 marks)
Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar’s value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit.
- How does a large financial (capital) account surplus allow the United States to maintain a large current account deficit? (2 marks)
The world now is actually on a two-currency standard — the dollar and the euro. China in effect has fixed its currency to the dollar for the last two decades, and the Japanese central bank only allows the yen to fluctuate within a limited range against the dollar.
- How do exchange rate controls by China and Japan reduce the likelihood that a weaker dollar will improve the United States’ current account balance? (2 marks)
So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks’ and private investors’ demand for dollars grow, and the current account deficit can be sustained.
- If investments in the United States began earning lower returns relative to investments in other countries’ financial and capital markets, what would ultimately happen to the US balance of payments in its current and financial accounts? Explain (2 marks)
The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”